Independent Contractor or Employee – Which Is Better?

By Marla Harding, CPA

The answer to the ever popular question, “Which is better, independent contractor or employee?” is, of course, “It depends.” It depends on whether you are the employer or the worker, and it depends on the specifics of your situation. But that’s the wrong question. “Which is better?” implies you are free to choose. In reality, the IRS holds the business owner responsible for correctly classifying the worker based on three guidelines: behavioral, financial, and the type of relationship. So, if you are looking to hire someone, that’s what you need to consider, not which is better.

Let’s go back for a moment and clarify which is which. An employee gets a paycheck from his or her employer. The employer is obligated to withhold taxes from the paycheck as well as to pay and file payroll taxes. So an employee always receives a net paycheck that is less than his or her gross wages. Many employees also get benefits from their employers, like subsidized health insurance and retirement. An independent contractor, on the other hand, gets full payment for services rendered with no taxes withheld and no benefits. It is the independent contractor’s responsibility to pay and file taxes, including self-employment tax.

On the IRS Web site, you will find lots of information on this very topic. Worker classification can be a gray area, but it’s worth your full attention because the penalties are very harsh. If you are about to hire someone, here are the things you need to consider:

1. Behavioral Control: This has to do with who directs and controls the work. An independent contractor would have much more autonomy than an employee. Generally they have special expertise.

2. Financial Control: An independent contractoris in business. He or she decides how much to charge, what tools or equipment to buy and what business expenses to incur.

3. Type of Relationship: Is the worker given the autonomy of an independent contractor, oris he or she given training, supervision and benefits like an employee?

EXAMPLE – Take, for instance, the computer guy who manages our firm’s computer network. He is an independent contractor. I don’t know what he does exactly, much less how he does it, or even when and where. Sometimes he works from home and sometimes we see him here. He gives me a bill each month, as he does his other clients, and I pay it. Contrast that with my bookkeepers, who work here in my office during set hours, whom I train and supervise and whom I decide how much to pay. Whether they are part-time or full-time, my bookkeepers are employees.

There’s a big danger in misclassifying workers. Employers like to treat workers as independent contractors because it’s easier and it saves money. But if the IRS gets involved and decides the workers should have been employees, there are huge penalties to pay on back payroll taxes. I have seen people lose their businesses because the IRS reclassified workers from independent contractors to employees.

So how does the IRS get involved anyway? It’s usually one of two ways. One way is if your return gets picked for an audit. Or, as sometimes happens, the IRS gets involved when a disgruntled independent contractor reports the employer to the IRS, claiming that he or she should have been an employee. This usually happens when the worker can’t pay his or her self-employment tax and feels the need to blame someone else. So, as an employer, you need to be very careful.

From the employer’s perspective, hiring independent contractors is much cheaper than hiring employees, unless the IRS gets involved. Take great care when you hire an independent contractor to be sure that you structure the position in such a way that it will withstand IRS scrutiny based on the three guidelines above. By the way, the IRS never goes the other way. They never say an employee should have been treated as an independent contractor. So, if you have any doubt, you can always hire a worker as an employee with no worries.

If you do hire an independent contractor, or you accept a position in which you will be paid as an independent contractor, here are some things you should know:

Employers hiring independent contractors should know:

An independent contractor should know:

Payroll Taxes

You don’t have to pay payroll taxes. This is a huge savings. FICA (Social Security and Medicare) is 7.65%, and then there’s federal and state unemployment. In round numbers, 10% might be a reasonable estimate of the payroll tax savings. That’s significant, not to mention that without employees there is no need to make payroll tax deposits, file quarterly payroll taxes and file W-2s at the end of the year.

You must pay self-employment tax. This tax is 15.3% of the profit. It is in addition to income tax. Whereas an employee pays 7.65% FICA,, and the employer pays 7.65% FICA, an independent contractor has to pay both halves, called self-employment tax. It gets added to your income tax on your federal return, so your quarterly estimated tax payments need to be large enough to cover it.

Workers’ Comp Insurance

You don’t have to pay workers’ compensation insurance. This can also be a significant savings, because workers’ comp insurance can be extremely costly depending on how dangerous the job is, i.e., how likely the worker is to get hurt.

You must pay your own workers’ compensation insurance.,If you are self-employed, you are responsible for obtaining your own insurance.

Benefits, Such As Health Insurance and Retirement

You don’t have to pay benefits for independent contractors. Another cost savings! Benefits are only available to employees. You don’t even have the option of including independent contractors in your health insurance or retirement plans.

You’re on your own. This isn’t really a problem for retirement, because it’s very easy to start your own 401(k)-K or other retirement plan. But it can be a real problem for health insurance, especially if you have a pre-existing condition.

Business Expenses

You get to deduct all legitimate business expenses, regardless of whether the worker is an independent contractor or employee.

You get to deduct legitimate business expenses (that have not been reimbursed). This can be a significant advantage over being an employee, but it is critical that you keep good records for any expenses incurred and any mileage driven. Business deductions reduce your profit, and save you both self-employment tax and income tax.

My Recommendations:

If you are an employer, you absolutely MUST file Form 1099-MISC for each independent contractor who earned more than $600 during the year. This isn’t really a recommendation. You are required by law to do it. Form 1099-MISC informs both the IRS and the worker how much they were paid during the year. It is critical that before anyone provides any services to your company, they fill out Form W-9, so you’ll have their name, address and social security number when you file the 1099-MISC in January.

If you are the worker being paid as an independent contractor, I have a few recommendations.

1. Use a separate bank account and track everything in QuickBooks (or a similar program). You’re in business now, and all of your earnings and expenses need to be accounted for. That way, you can reconcile the account each month and know exactly where you stand in terms of profit. It will help you plan for taxes, and it will help you tremendously in an audit.

2. Do not underestimate your tax liability. Many new independent contractors get caught short at tax time. It’s different for everyone, but I think putting away one-third of the profit for your quarterly estimated tax payments is a good starting point.

3. Contribute to your retirement. It is extremely easy (and cheap) to set up an IRA, a SIMPLE IRA, SEP IRA or a 401(k). There is no excuse for not saving for retirement, and it will help reduce your taxes. It’s a win-win.

My recommendation for everyone is to get professional help from a CPA. There are a lot of things to consider when you hire for the first time, and mistakes can be extremely costly. It’s worth consulting a professional to make sure you classify your workers correctly and file all the payroll taxes and information returns on time. Call me—we don’t charge for initial consultations.